Is now the time to turn to private markets? 

A rapidly evolving macroeconomic environment means investors should consider asset classes with inflation-hedging capabilities.

Today, investors are facing threats to their portfolios on the back of a troublesome macroeconomic climate. In mid-November, the International Monetary Fund (IMF) said the global economic outlook is set to look even gloomier over the coming months. Ahead of the G20 summit in Indonesia, the global lender said: "The challenges that the global economy is facing are immense and weakening economic indicators point to further challenges ahead.”

For now, this leaves investors in a precarious position with efforts being made to protect their investment portfolios from the threat of economic contraction. Attention is shifting to assets with inflation-hedging characteristics, and investors are prepared to look outside of public markets to capture these characteristics. 

One factor that supports the case for alternative investments is that historically, the correlation between public fixed income and equities has risen during inflationary periods, meaning investors may need to look beyond traditional asset classes to protect their portfolios.

Essential infrastructure

Within private markets, infrastructure is typically seen as the “go-to” asset for inflation protection. Many infrastructure assets, such as electricity utilities, have strong pricing power, which enables them to pass on rising input costs to customers. Moreover, the essentiality of infrastructure, coupled with typically high barriers to entry and inelastic demand for their services, allows for many infrastructure assets to demonstrate rising revenues in times of rising prices.  

While infrastructure covers the core subsectors of social infrastructure, utilities and transportation, newer areas such as digital infrastructure and energy transition infrastructure are emerging as the latest evolution of the asset class. 

Renewable energy production and energy storage have become more mainstream alongside telecommunications towers, data centres and fibre optic networks, resulting in a broad range of distinct assets that provide a variety of risk and return profiles.

The degree of innate inflation linkage within these assets varies, but a low correlation to other asset classes, low levels of volatility and the intrinsic value of infrastructure assets makes private market infrastructure investments an attractive option.

Private debt and real estate

Infrastructure isn’t the only potential solution when it comes to protecting portfolios from inflation, with private debt rising in prevalence over recent years.

Private debt investments offer indirect inflation protection as many of these instruments pay interest on a floating rate basis, meaning when interest rates rise across the globe, the return potential from private debt starts to rise.  

Furthermore, as liquidity from public markets dries up, companies are increasingly turning to private debt providers to deliver funding.  These supply and demand dynamics are enabling these private lenders to increase their spread and offer even more attractive returns to investors. 

On the flip side, there is of course the potential – and perhaps the expectation – that default rates on these loans will rise as economic conditions across the globe deteriorate.  However, this rise is starting from a very low level.  Furthermore, many of the highest-rated private debt managers in Mercer’s universe have a strong focus on defensive, non-cyclical sectors, focusing on lending to quality companies with durable cashflow generation, whilst also incorporating robust lender protections into their loan contracts.  A diversified private debt portfolio, incorporating high-quality managers with superior sourcing capabilities, could therefore be expected to outperform in the current rising rate environment, delivering potentially attractive yields to investors.

Real estate is another important pillar of the private market universe, with inflation-hedging traits available through specific segments of the market where there is more scope to raise rents, as well as to sectors that will benefit from long-term themes and trends.  

Whilst performance can vary significantly by geography, broadly speaking, niche sectors that may fare relatively well include elderly housing, life science office space, and student housing.

Could private markets be the answer to investors’ search for inflation protection? Perhaps.  Targeted segments of each of the main private market asset classes provide opportunities for inflation protection and increased returns with rising rates and diversification from traditional asset classes.  The key to success is to understand what you want to achieve through your private markets allocation and build a diversified portfolio of high-quality funds, targeted to your specific needs.